I can’t tell you how excited I am to talk about one of my favorite concepts in all of social science. It’s about risk and here’s the story.
The story goes that Samuelson, the famous economist, walks down the corridor and meets one of his friends. He says, “I have a bet for you. I’ll flip a coin. If it comes up heads, I’ll give you $1,100.” (The actual numbers were different, but it was many, many years ago so we’ll make it $1,100.) “If it falls on tails, you’ll give me $1,000.” So, $1,100 - $1,000. And he asked his friend, “Do you want to play?” And his friend said, “No. I know that the expected value is positive. $1,100 - $1,000. I know that on average it’s a good bet, but I don’t want to play because if I win $1,100 I’ll only be slightly happy, and the feeling will go away soon. If I lose $1,000, I’ll beat myself over the head for a long time for making this mistake, how terrible, how stupid, and so on. So I don’t want to play.” Then Samuelson asked, “What if we play a thousand times?” His friend responded, “A thousand times? That’s an amazing expected value. Of course I want to play!” Samuelson then says, “We’re not really going to play but listen to what you’re telling me. You’re telling me that if I came to you every day and asked if you would like to bet $1,100 - $1,000, every day you focus on the downside and say it’s not worth it. After a thousand days, let’s say almost three years, you would look back and say that you made a mistake, and you should have played that game.”
Now what is this story about? This story is about our inconsistent preferences that when we look at risk one at a time we focus on the losses and what we stand to lose. But when we look at the portfolio of risk over a thousand opportunities, we say, “Oh, I wish I’d played.” Now, of course, life doesn’t give with us the same coin toss opportunity every day. But imagine it over the lifetime, you have opportunities for different risks. Sometimes it’s
1,200 - 800. Sometimes it’s 1050 - 950. But life gives us lots of opportunities that are about risk taking. How much risk should we take? And the Samuelson story basically says that when we think about risk, we shouldn’t think about it as one option at a time. Because when we think about it this way we don’t want to take the risk. But when we think about a lifetime of risk, we wish we would have taken more.
The story points to the problem that we focus on one risk at a time. But it also tells us something about the solution—that the right approach to risk is to look at it as a portfolio. Even if it’s a one-time thing, there will be many types of risks. We should look at them as a portfolio and ask ourselves, if these are the kinds of risk that we would be taking if they were offered to us many times. So, Samuelson’s friend should have said, “This bet is one option (1,100 - 1,000) and if I was offered the bet 1,000 times, I would take it. So maybe I should also accept the bet when it’s offered only one time.”
Now, we still have loss aversion and we still have regret. But, in general, taking those risks would be better in the long term. So, to framing risks in a better way, to thinking long term and taking the kind of risks that we should be taking. To all of us, a good, risk-filled life.
